Taking a long-term view on commodities

As a forecasting tool, the model’s fit was good enough that it was logical to extend it to other commodity markets. The economic theory is the same as that for gold. Commodities are hard assets and stores of value in an inflationary environment. Of course, most commodities are more than simply stores of value. They also are important flow variables in the world economy. Moreover, commodity production costs are continually changing. They may be in long-run uptrends because, for example, a metal’s easily minable ores are being exhausted. Or, they may be in extended downtrends because of the development of more-effective production techniques, such a horizontal drilling for natural gas. These factors are not reflected in the model, so won’t be as good of a fit as that for for gold.

“Coffee matters” (below) shows the same scatter graph for New York Arabica coffee. Coffee was selected because it has had a major downtrend, hence it might be undervalued.

The fit is still fairly good; the R-squared is 55%. Sure enough, the model is forecasting that coffee in 10 years will rise from the current $1.22 per pound to $1.73. This sounds fairly bullish, although owning coffee on the futures’ board will cost you carry.

Fortunately, there are cheaper ways of going long coffee for the long run. For example, you could invest in coffee-producing plantations. Larger traders with experience in physicals can store coffee at costs much lower than those afforded by the futures market. Another idea would be to take advantage of the undervaluation by buying companies that use coffee as an input, such as Smuckers (SJM), which sells Folgers.

This analysis has been conducted for all the commodities in the International Monetary Fund’s Commodity database. But some of the best opportunities come in commodities not traded on public exchanges. For example, hardwood (mahogany) prices (see “Wood gains,” below) are forecast to increase by an inflation-adjusted 40%. After inflation, that’s 70%. Because there is no public futures market for this particular commodity, an investor would have to find a timber or lumber company that would benefit from the coming bull market.

Burton Rothberg is a professional trader and a consultant to hedge funds. He can be reached at br@banachcapital.com.